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A World Of Difference For Private Equity

PE investors are bracing for the familiar combustible effects that invariably follow when a plentiful supply of dry powder mixes with record levels of available debt: hot competition to land deals and higher acquisition prices. But as we describe in Bain & Company’s Global Private Equity Report 2013, two factors in particular—sharply divergent growth prospects in different regions of the world and a pick-up in sponsor-to-sponsor transactions—will give deal making in 2013 a distinctive character.

The regional growth factor. Differences in economic outlook across the globe will sharpen the regional flavor of investment activity. In North America, continued confidence that the US economy will stay on its recovery course in 2013 will be essential for buyer and seller price expectations to remain aligned. However, lingering doubts persist as to whether the economy will strengthen or stall. One overarching positive is monetary policy, which will remain loose throughout the year, giving room for the debt markets to increase the number of deals that will get done in 2013.

The deal environment in Europe will be more problematic. For activity to pick up this year, PE funds would need to see stronger economic growth ahead. Buyers and sellers also need to coalesce around a common and realistic view about the region’s longer-term growth prospects in order to bring prices down to levels that are more likely to clear the market. On both scores, Europe continues to look like a dicey proposition for deal making in 2013.

PE’s prospects in the rest of the world remain largely tied to macroeconomic conditions in the big emerging markets of Asia and Latin America. China’s economy looks poised to accelerate in the near term. Longer term, however, China’s growth potential will slow sharply as factors that acted as a tailwind for GDP—strong capital flows, favorable export conditions and a growing labor force—are now reversing and beginning to weigh the economy down. GPs are holding on to a large amount of dry powder they are trying to put to work. But the PE industry has not experienced an economic cycle like China’s current one, and the lack of clarity will make it difficult for the gap between buyers’ and sellers’ value expectations to close.

India’s economy has recently hit a weak patch and will not provide much lift for PE investments in 2013. The PE industry is laboring under the burdens of high asset prices, the reluctance of Indian business owners to sell controlling stakes in the companies and virtually no viable exit options to provide liquidity. Until these structural barriers are addressed, India will continue to be a challenging deal making environment.

Investors in Brazil will face a reasonably good climate for PE but an uncertain economy. PE funds that target Brazil continue to attract dry powder, ensuring that deal making will remain active. There are good deals to be done at reasonable prices, but they are becoming harder to find as competition heats up. PE investors are not getting much help from Brazil’s economy, which is slowing under the weight of heavy-handed government tax, export and interest-rate policies.

The sponsor-to-sponsor conundrum. The second big feature that will dominate deal making in 2013 will be the continued popularity of sponsor-to-sponsor transactions, which is sure to reignite the controversy over whether sales of assets from one PE fund to another are good or bad for investors. Sponsor-to-sponsor deals have long raised the hackles of LPs, who are concerned about their “frictional costs”—the double-barreled transaction fees that cut into returns for LPs who are both in the selling and buying of funds. They are also skeptical that the new PE owners of the companies at the center of the transaction have truly distinct skill sets that will enable them to find ways to create value that the original PE owner did not already extract.

Those concerns and many others have attracted recent academic scrutiny. Performance data show that sponsor-to-sponsor deals did underperform other types of deals slightly on an absolute return basis—by 3 percentage points, on average, in the years prior to 2004, and by 8 percentage points since then, according to PERACS, a PE performance analytics company (see Figure). Intriguingly, however, sponsor-to-sponsor deals show a significantly lower variation in the returns they generate, making these deals a lot less risky. As awareness of these results spreads, LPs should come to look more favorably upon sponsor-to-sponsor deals.

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